Our 2007-2008 Gulf 321 margin forecast is lifted 15% to 20% to $11.50 per barrel and $9.50 per barrel while our oil-price forecast remains $62.50 per barrel and $60 per barrel, respectively.

The right assets and the right markets drive cash flow. Different markets warrant different strategies. Exposure to Asia is the best option for growth. Leverage to the stable U.S. market ensures high cash returns, especially for more complex refineries. Europe's growing diesel deficit necessitates massive reinvestment, limiting free cash flow.

Downstream asset repositioning to accelerate: Global Integrated Oils should continue to divest, swap or joint-venture refining assets. We favor strategies to lever the Pacific Basin and U.S. West Coast while redirecting cash upstream. Cash demands are high due to cost overruns and buyback commitments further encouraging action.

Based on comparisons of multiple value and operational metrics,
Marathon Oil
and
ConocoPhillips
stand out as having the best systems to the end of the decade, although the very U.S. exposure that contributed to excess returns is a risk given the expected strength in Asian and Middle Eastern markets post-2010. Continued outperformance requires that growth in the Atlantic Basin demand will continue to outpace global demand.

Marathon's disproportionately large earnings contribution is due to strong U.S. Midwest refining margins driven by crude oversupply in the region.

The next best performers --
Exxon Mobil,Royal Dutch Shell
and
Chevron
-- have differentiated reasons for strong performance. Our favorite among the three in terms of best downstream exposure going forward is Chevron due to its growth strategy in the Pacific Basin and India and its leverage to the U.S. West Coast.

Exxon Mobil should sustain profitability and a high return on investment although it has relatively less growth. Royal Dutch has taken the first steps toward improving returns with its planned divestments of Organisation for Economic Co-operation and Development (OECD) assets for higher-growth markets.

In terms of valuation, downstream earnings and cash flow remain a secondary factor in the performance of these companies as only 15% to 30% of group earnings are from the downstream (Marathon is the outlier at 60%). Translating earnings and cash flow into company valuation leads us to conclude that
BP
and Chevron's downstream businesses are worth more than what may be applied from a straight earnings contribution by business in 2006.

BP has the ability to improve operationally to close its valuation gap. BP's scope for operational and reputation recovery rests with Texas City. Chevron has well-positioned U.S. assets and looks set to deliver downstream earnings growth through investment in Asian positions funded by strategic divestments.

Exxon Mobil's historical positioning entitles it to superior cash flow today, which is being reinvested upstream or spent on buybacks.

Our view on integrated oils is still positive with 10% average upside. Our core sector outlook is positive due to our conviction in a suspended oil cycle and $50 per barrel or more oil price to end-decade. Stronger refining margins, especially in the U.S. and Asia, further support cash flows and valuations, and make us lift 2007 estimated earnings 3% to 15%. Targets are bumped 1%-4%. Relative to consensus, earnings are now 3%-5% ahead of the 2007 and 2008 mean.

-- Daniel L. Barcelo, CFA

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